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US Commercial Service The JLJ GroupChina Franchising Industry

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INTRODUCTION

The objective of this report is to provide an overview of the Chinese franchise market1

with focus on foursectors: food & beverage, apparel, education, and fitness, beyond the already established cities ofShanghai, Beijing, and Guangzhou.

EXECUTIVE SUMMARY

Market overview.There are an estimated 2,600 brands with some 200,000 franchised retail stores inover 80 sectors. Franchising has also experienced significant growth in the last few years due to risingdisposable incomes and an increasing number of Chinese entrepreneurs willing to adopt franchisingmodels.

Regulatory environment. Chinas first franchise law was enacted in 1997, but there were severaluncertainties and grey areas, particularly for foreign franchisors. More regulations were issued in 2005and in March 2007, which further clarified the law; for example cross-border franchising

2, which was

previously in a grey area, is now permitted. This opens up opportunities for mid-sized US franchisorsthat do not necessarily want to or have the resources to set up a legal presence in China.

Key sectors.The franchising model has been used to different degrees in the four sectors analyzed inthis report. The F&B sector was one of the first to use franchising in China, but majority of franchisorsare domestic; many international F&B brands have few franchised stores in China. In the apparel sector,franchising is mainly used to expand in Tier 2 or Tier 3 cities, while stores in Tier 1 markets are usuallykept as direct-owned outlets. There is a large presence of foreign companies in both the education andfitness sectors. In education, the use of franchising is limited by regulations. In the fitness sector,franchising is still a common strategy for expansion, although several large gym chains are movingaway from it and using J oint Ventures or direct-owned stores instead.

Key emerging markets. Key Tier 2 emerging markets for franchisors are still concentrated on the EastCoast, e.g. Qingdao and Nanjing. Inland Tier 2 cities such as Xian and Chongqing offer potential inthe longer term since disposable incomes there are still relatively low. It is generally difficult to find goodpotential partners in Tier 2 cities, and many strong hospitality groups are large domestic or Hong Kongcompanies with a national presence.

Key opportunit ies and challenges.There are good opportunities in all four sectors for US franchisors,especially for mid-market or high-end brands. However, there are several key challenges to adoptingthe franchising model, including the difficulty of finding good partners or franchisees, lack of control overstore quality, need for localization, etc. Companies need to be prepared to invest a significant amount oftime, commitment, and resources to manage China operations.

Market access. Foreign franchisors can enter via either cross-border franchising or establishing a local

legal entity (WOFE/J V

3

). If the local legal entity is to be a franchisor, it must operate two direct-ownedstores for at least one year, before it can have franchisees. However, more time is still needed toobserve how the new franchising law is implemented. Although a higher capital investment is needed toset up a direct presence in China, it offers the foreign company greater monitoring/control over Chinesefranchisees.

1Franchising refers to the practice where the franchisor grants the franchisee the right to use a developed concept (including trademarks and brandnames, production, service and marketing methods and the entire business operation model) for a fee. Franchisees supply the capital and staff.2 Where the foreign franchisor signs a franchise contract with a master franchisee in China, without establishing a legal presence in China3Wholly-owned Foreign Enterprise or J oint Venture

CHINA: Franchising Industry

Access Dynamic and Emerging Markets

The J LJ GroupSeptember 2007

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INDUSTRY OVERVIEW Return to Top

Market overview. Chinahas 2,600 franchise networks4

operating in the first quarter of 2007 and over200,000 franchised outlets. However, many of these franchises are domestic brands and small in scale,with an average of 73 outlets per franchise brand

5, compared to over 540 in the US. The limited useof

franchised stores also reflects the key challenges to adopt this model, for example, regional differences

and quality of local franchisees/partners.

Market g rowth. Growth in sales from franchised stores has averaged 35-40% in the last few years. In2006, sales from franchised outlets grew by 40%, compared to 10% for retail outlets in general.Currently, franchising in China only accounts for 3% of total retail sales compared to 40% in the USand about 10% on average in Europe. Thus, there is still significant growth potential in franchising.

Drivers of growth. On the demand side, growth is driven by an expanding consumer market, adeveloping urban middle class, rising disposable incomes, and changing customer attitudes. On thesupply side, an increasing number of Chinese companies are using the franchising model to expand.Also, more Chinese entrepreneurs are willing to be franchisees for foreign brands, and have thefinancial resources to do so. In addition, the Chinese market has become more attractive to foreignfranchisors since the regulations newly introduced in March 2007 address many previous issues thatwere unclear in the previous regulations. [see section on Regulatory Environment for more details.]

Key sectors.The franchising model is adopted in over 80 sectors. In2005, 34% of franchised storeswere in food and catering, 31% in retailing, and 35% in the service (includes laundry, property agents,copy-shops, etc.) sector. Companies with existing chain stores

6 have used franchising to expand 69%of chains adopted the franchising model at the start of 2007. In particular, fast food chains rely heavilyon franchising 95% have used franchising to expand.

Franchised Stores by Sector

31%

34%

35%

Retail

Food & Catering

Services

Source: Ministry of Commerce

Regulatory Environment Return to Top

Regulatory developments. Chinas first franchise law was enacted in 1997 by the Ministry of DomesticTrade, which did not make clear provisions for foreign companies. In 2005, the Ministry of Commerce(MOFCOM) released hastily due to WTO commitments drafted measures applicable specifically toforeign franchisors. This document confirmed that foreign companies must establish a legal entity inChina before they can engage in franchising; however many other issues were still unclear, includingthe legality of cross-border franchising. In March 2007, further updates (The Regulations, The Record

Filing Measures and The Information Disclosure Measures) to the existing regulations wereannounced, which addressed many of the grey areas. These new amendments form the new regulatoryframework for franchising. The following are the most important aspects of the updated regulation. Itmust be noted that these May 2007 regulations are still relatively new, and more time is needed to seethe actual implementation.

4 Refers to a system of franchisees under the same network. A franchise brand may have more than one franchise network, e.g. it has a fewregional master franchisees, which in turn further sub-franchise.5Includes Chinas large franchise brands, with thousands of outlets, as well as the multitude of small brands, with only a few outlets each.6 While franchises are always chain stores, the opposite does not hold true.

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KEY INDUSTRY 1: FRANCHISING IN FOOD & BEVERAGE

Summary: Franchising in F&B sector Return to Top

Franchising is frequently adopted especially in the fast food and casual dining segments. The mostcommon franchises are domestic and Taiwanese brands, serving mainly Chinese/Asian food. Many

international and Hong Kong brands choose direct-ownership over franchising, due in part to concernsover brand/quality control. Large players like KFC already have a strong presence in Tier 2 and evensome Tier 3 cities (e.g. Kunshan), but largely through self-owned stores. KFC, for example, has 2000stores in China, but only 2% are franchised. In contrast, more recent entrants rely heavily on thefranchising model to close the gap between them and established market leaders e.g. 90% ofPapaJohns shops are franchised.

Market Overview Return to Top

F&B market. Eating is a fundamental component of the Chinese culture about one-third of totalhousehold expenditure is spent on food and about 20% on dining out. Annual revenue generated by theF&B industry

10has increased at about 19% CAGR from 2003 to 2006 to reach $137 billion. In particular,

sales revenue from F&B chain stores grew at almost 40% CAGR in the same period to reach $7.3billion in 2006.

Chain stores. Domestic companies represent the majority of chains (2006: 73% of chain stores, 250+brands), followed by foreign (20%, ~70 brands), and Hong Kong/Taiwan chains (7%, ~26 brands).However, although there are less foreign-invested companies, they generate sales near equivalent tothat of Chinese companies, as shown in the chart below.

F&B Chain Store Sales by Origin, 2002-2006 [US$, Billion]

0.3 0.3

3.72.22.81.41.1

0.50.5

0.4

3.12.52.11.71.2

0%

20%

40%

60%

80%

100%

2002 2003 2004 2005 2006

Int'l HK/TW Domestic Source: National Bureau of Statistics.

Franchising. By the end of 2006, 95% of fast food chains were using the franchising model on somescale. Sales from franchised F&B stores increased 43% CAGR from 2003 to 2006 to reach $2.54billion. The relatively low sales of franchised stores compared to total F&B chain store sales (which is$7.3 billion) can be attributed to the relatively limited number of franchised stores among internationalchains, which usually generate higher total sales than Chinese chains. To compare two similar-sizedbrands in terms of total number of China stores: Dicos Fried Chicken (majority franchised stores)generated $0.2 billion in retail sales while McDonalds (very few franchised stores) was about $0.4billion (2006).

Market segments. Fast food is the fastest growing segment in the F&B sector.Sales grew at 157%CAGR between 2003 and 2006 to reach $2.9 billion. 42% of fast food chains are international brands,about 45% are Chinese chains, and the rest are Taiwan/Hong Kong chains. The number of Chinesefast food chains also increased faster than international ones - 21% CAGR for Chinese compared to11% for international. Another key segment, especially for foreign franchisors, is casual dining. Thecasual dining market was valued at about $3.3 billion in 2006. Of the casual dining market, pizza is thelargest segment, accounting for about 45% of all casual diners. Other segments include coffee shops,local food chains, and restaurants.

10 This includes chain stores and stand-alone stores that employ a minimum of 20 people including restaurants, fast food shops, coffee shop, icecream shop, etc.

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Key trends. Growth is mainly driven by rising disposable incomes; rapid urbanization and busylifestyles also create an increasing demand for eating out and for fast, convenient meals. The GoldenWeek holidays in China are also key time periods for spending and eating out. Annual per-capitaspending on dining-out is expected to increase by about 15% to reach $120 in 2007. For Chineseconsumers, atmosphere, cleanliness, and hygiene are becoming increasingly important, besides price.

Competitive Landscape Return to Top

Foreign vs. domestic. In terms of number of stores, foreign chains generally lag behind Chinese andHong Kong/Taiwan-invested ones. Domestic brands have stronger market penetration (especially inTier 2 or 3 cities) as they are generally more affordable. Large foreign chains that entered China early,e.g. KFC, are usually present in Tier 1 and 2, and some Tier 3 cities. Relatively newer entrants are stillpredominantly located in Tier 1 cities, e.g. out ofPapa Johns 51 shops, only about 9 are in Tier 2.

Investment model. Although large foreign brands have a well-established presence, most retain directownership through a WOFE or J V with a local partner. For example, successful international franchisebrands like Pizza Hut or McDonalds have none or very few franchised stores in China. Three keyreasons for this: 1) difficulty in finding good franchisees, 2) protection of brand image/product quality, 3)higher revenue/profits from direct-ownership of stores. On the other hand, relatively new entrants, suchas Papa Johns and Burger King, have either adopted or plans to adopt the franchising model to expandquickly (see table below).

Table 2 Key Chain and Franchised stores in F&B sector

BrandYear ofentry

Totaloutlets

Franchisedoutlets

Location Notes

International franchisors without franchised outl ets in China

Pizza Hut 1990 250+ 0 National- Very popular casual dining brand- Limited localization

Yoshinoya 1992 110 0 East China- Beef and rice diner.- Low prices and localized offerings.

Hagen-Dazs 1996 50 0 East China- Rather successful- Premium positioning

Burger King 2005 9 0 East China

- 3 franchisees in Beijing currently beingfinalized

- Plans aggressive franchising: 1000franchisees in the next 10 years.

International franchisors with franchised outlets in China

KFC 1987 1800+ 37 National- Largest and most popular fast food chain- Low prices and localized menu

McDonalds 1990 750 1 National- Menu largely similar to US; price comparable

to KFC- 4 more franchisees to be added by end-2007

Subway 1995 61 61East China& Sichuan

- Product offering not localized, but localcondiments offered

Papa Johns 2003 51 46 East China- Pursuing localization- Rapid franchising to close gap with rivals

Hong Kong & Taiwan franchisors

UBC Coffee (TW) 1997 1000 850+Shanghai andSouth China

- Largest franchise chain in China- Experiencing issues with franchisee quality

Dicos FriedChicken (TW)

1989 600+ 512 National- Third largest fast food brand in China- Low price targeted to young masses

Chinese franchisors

Chongqing

Dezhuang1999 408 370

Mid- & West

China

- Casual diner with good reputation

- Traditional Chongqing-style hotpot

Malan noodle 1995 381+ 300Northeast

China- Popular Chinese fast food noodle chain- Targeted to mass market.

Inner MongoliaXiaofeiyang

1999 326 249 National- Casual dining, Mongolian cuisine- Targets families

Note: Data for Mainland China, no. of outlets estimated; national presence refers to stores in almost all provincial capitals and other cities,East China refers to cities along the East coast, spreading from Guangdong in the south to Liaoning in the north; Mid China includesSichuan, Chongqing, Wuhan, Shaanxi, etc;. Source: Company websites, phone interviews, news articles, and J LJ analysis.

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Key Opportunities Return to Top

With changing consumer preferences and rising requirements on store/food quality, there are goodopportunities for US franchisors, especially in areas where domestic companies are weaker.

1. Casual dining There are currently limited number of foreign casual diners in Tier 2 cities,

representing good opportunities for US franchisors. Consistent quality, marketing, and brandexperience is increasingly appreciated. Currently many domestic chains are hampered by a lack ofclear standards and identity across outlets. For example, Tujia Bakery is marked by differences iningredients and preparation methods across stores.

2. Innovative products An increasing number of consumers are interested in new experiences, anddomestic chains often cannot deliver these as they lack R&D / product innovation. Foreign chainsare significantly stronger in this area. For example, Starbucks frequently experiments with newlocalized items, such as Red Bean Frappucinos and sweet mooncakes.

3. Organic ingredients Burger King has begun introducing organics into several internationalmarkets while in the US, Chipotle and ONaturals represents a new type of organic fast food brand.Several food scares and a growing environmental awareness among Chinas middle class aredriving up demand for organic ingredients, offering long term opportunities in this segment. Papa

Johns is already focusing its marketing on fresh ingredients to gain an edge over Pizza Hut.

Key Challenges Return to Top

Despite opportunities and strong management skills of foreign (and US) chains, there are several keychallenges that must be overcome:

1. Finding good partners and franchisees - Chinese companies may not have a goodunderstanding of franchising and lack modern management practices. For example, Chinese chainXiaofeiyang is closing franchised stores that do not meet its quality standards. On the other hand,many new foreign entrants often have unrealistic expectations of local partners or franchisees.Companies need to be prepared to spend more time to train franchisees in China compared to US.

2. Localization The Chinese palate differs greatly from the US one; there is also great regional

variety, e.g. Southeastern food is bland while Sichuan food is very spicy. KFC appeals to localtastes by offerings such as spicy chicken burgers and mushroom chicken congee. Conductingconsumer research (e.g. focus groups) is usually needed for testing menus.

3. Strong competition Competition is intense, with many large and medium-sized internationalchains already present in China and offering similar menus, (e.g. Hard Rock Caf, TGI Fridays).Many of the most successful international chains engage in aggressive marketing and advertisingcampaigns. KFC, for example, is known for its creative commercials which are updated frequently.

Case Studies Return to Top

Burger King A relatively late entrant to the Chinese market, the company opened its first store inShanghai in 2005, where the brand was well received. Burger King has developed a loyal followingamong local teens, white collars, and expatriates. Before their official entry, Burger King ran a small

pilot restaurant in a hidden location, where it analyzed local tastes and adapted products to the localmarket. The company is in the process of finalizing 3 franchisees in Beijing. More are expected to followas the company has announced an aggressive franchising strategy to catch up with other moreestablished fast food established brands.

Papa Johns Has been expanding rapidly since its entry. At first, stores were run by a masterfranchisee, Shanghai RCS Group Co. Ltd. After establishing a good store network and brand image,Papa Johns allowed RCS to engage in sub-franchising in 2006. In the next decade, Papa Johns plansto add about 200 direct-owned and franchised outlets outside its base in Shanghai. To support thisexpansion, web conferencing is used for all meetings with international staff and to review store layouts.This has significantly decreased traveling costs of staff.

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KEY INDUSTRY 2: FRANCHISING IN APPAREL

Summary: Franchising in the apparel sector Return to Top

Franchising is popular in the casual wearand sportswearsegments. Foreign franchisors among whichmost are European brands have a competitive advantage in areas such as supply chain management,

branding, service, and quality. Hong Kong brands (such as Giordano, Esprit) are also successfulbecause of a combination of international management skills and a better understanding of theMainland market. However, domestic franchisors are increasingly competitive, and are increasingly ableto offer apparel with fashionable design at competitive prices.


Apparel sector & chains. Total retail sales for the apparel industry reached $96 billion in 200611

, a15% growth over 2005. In 2006, there were about 5,400 apparel chain stores with total retail sales ofabout $0.7 billion

12. Expansion of apparel chains into Tier 2 and Tier 3 cities is a key trend. In March

2007 Li-Ning announced new stores would be located mainly in Tier 2 and Tier 3 cities while Espritalready operates in Tier 3 cities such as Guiyang and Changzhou.

Franchising. Franchising is popular in sportswearand casual wear, e.g. Nike and Vero Moda, where

growth in the number of franchised stores is faster than that of direct-owned stores. While less popularin the childrens wearand underwearsegments, the number of franchised stores is still increasing atfaster rates than direct-owned stores.

Drivers of growth. Growth is driven by the growing middle class, especially young office-workingwomen, who are a key customer group. Growth in the childrens wear segment is partly fuelled by theone-child policy, which results in extended families focusing significant spending on one child,commonly known as the little emperor phenomenon.

Market Segments Return to Top

Ladies wear. Sales have been growing ~20% annually. Foreign brands (Etam, Esprit, Only) dominatedthe top 3 in 2005 through quick response to needs and localized designs. However, the top 10 brandshave only a 20% market share. Knitted underwear, of which ladies underwear has the largest potential,

is expected to grow at rates of 20% annually in the next decade. Foreign brands are limited to thepremium segment. In 2005 the top 10 underwear brands accounted for about two-thirds of the market.

Childrens wear. One of the fastest growing segments with about 8% annual growth, and expected toreach ~17% from 2010 onwards due to an expected baby boom from 2007 - 2012. Foreign brandscaptured a 50% market share, while the top 10 brands held a combined market share of 30% in 2005.

Casual wear. Casual wear sales only accounts for 7.5% of total apparel sales; however growth rates of10% are expected in the next few years. Demand is rising as more office dress codes are less strict.

2005 Share of Sales per Segment

17%

29%

7%

39%

8%

Knitted

Ladies' Wear

Casual Wear

Others

Children's Wear

Source: China National Commercial Information Center

11Includes all outlets (e.g. department story, specialty store, chain store, etc.) irrespective of the number of employees.

12 Retail sales from chain stores are low compared to total apparel retail sales, as the main apparel sales channels are individual shops/stands (low-end, unbranded apparel) and department stores (mid-high end)

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Sportswear. Experiencing double-digit growth since 2000 and expected to reach $6.2 billion by 2008.Popularity is fuelled by greater health awareness, changing lifestyles, and the Olympics.The segment isdominated by Nike,Adidas, Li-Ning,Anta, and Reebok, with a combined 40% market share in 2006.

Competitive Landscape Return to TopGeographic distribution. Domestic, Hong Kong and foreign brands are found throughout Tier 1 and 2cities. The largest brands, such as Li-Ning and Esprit, are also present in Tier 3 cities. Products sold inTier 1 cities are differentiated and targeted towards specific customer groups (e.g. young people intoalternative fashion) while products in Tier 2 and 3 markets are still more generic. However, productdifferentiation in Tier 2 cities is expected to increase rapidly.

Investment model. Domestic brands predominantly rely on the franchising model to expand. On theother hand, there is no dominant investment model for foreign brands Etam has both direct-ownedoutlets and J Vs, Vero Moda franchises in secondary markets, and Esprit uses franchising in primaryand secondary markets. Among foreign franchises, the majority are European companies; majorAmerican fashion brands, like Gap13, are not yet in China.

Table 3 Key franchised chains in apparel sector

BrandYear of

entry

Total

outlets

Franchised

outlets

Location Comments

Foreign Franchisors

Nike 1980 3174 2700+ National- Targets young segment- Prices similar to US and Europe

Jeanswest 1993 1300 950+ National - Targets young segment, mid-end & premium

Esprit 1992 300+ 270 National- Targets the 25-40 age group.- Plans to enlarge to 600 in the coming years

Vero Moda 2001

70014 300 East China

- Targets young females, mid-range pricing

Jack & Jones 1999 - Mens fashion with focus on jeans, mid-range

Only 1996 - For young women, mid-range pricing

Hong Kong Franchisors

Baleno (HK) 1996 3700 3327 National- Casual wear for the average consumer- Low prices

Giordano (HK) 1992 728 644 East China - Casual wear, mid range

Bossini (HK) 1993 449 150+ East & Mid - Casual wear, low-mid range

Domestic Franchisors

Li-Ning 1990 4297 3860 National- #1 domestic sports brand.- Perceived as equal to Nike, but lower price- Entered the European market April 2007.

Metersbonwe 1995 1800 1450 National- Casual wear, targeted at young age group- Mid-range

Youngor 1979 1500 1200 National - Casual wear and costumes.

SeptWolves 1990 1200 1000 East & Mid - Casual menswear.

Baoxiniao 2001 600 551 National - High-quality suits.

Note: Data for Mainland China, no. of outlets estimated; national presence refers to stores in almost all provincial capitals and other cities,East China refers to cities along the East coast, spreading from Guangdong in the south to Liaoning in the north; Mid China includesSichuan, Chongqing, Wuhan, Shaanxi, etc;. Source: Company websites, phone interviews, news articles, and J LJ analysis.

Key trends.As consumers become more sophisticated, the market structure is shifting from one withfew varieties, high volumes, and long product life cycles to one with more variety, small volumes andshort product life cycles. This is partly led by the successful entry of fast fashion brands like Zara andH&M in Tier 1 markets in the past 1-2 years. In coastal cities, strong brands, design, and quality areincreasingly valued over low prices. Other segments which are increasingly popular include casual wearand apparel made of natural fibers, especially cotton.

13 Gap is currently present in J apan, Singapore, Indonesia, Malaysia and India. It only recently entered South Korea; the company has notannounced specific plans for China.14Vero Moda, Jack & Jones and Only are owned by Bestseller; each store usually carries all three brands

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Key Opportunities Return to Top

Chinas middle class and young consumers are increasingly drawn to branded apparel that can expresstheir individual lifestyle and tastes. This gives US brands chances in areas where local brands areweaker.

1. Well-known brands While foreign brands cannot compete on price, they generally have stronginternational brand image. This enables foreign companies to sometimes position their products asmore high-end than they are in their home market. Etam, for example,used this strategy when itentered the Chinese market.

2. Fast fashion Chinese brands invest only less than 0.2% of sales revenue in supply chainmanagement and R&D. Thus, they generally have slow turnaround times from design to production,and are unable to constantly introduce new products, unlike international fast fashion brands likeZara orH&M.

3. Fashion accessories Fashion accessories are an untapped market in China, where marketpenetration is less than 5%. Rates for Japan (98.2%), Thailand (68%), Hong Kong (54%),Singapore (48%), and Malaysia (47%) indicate strong growth potential. Current growth rates foraccessories is about 19% annually. H&M and C&A, for example, both offer accessories in addition

to clothing.

Key Challenges Return to Top

Foreign brand apparel is generally readily accepted in China, although there are still some regionaldifferences.

1. Marketing Aggressive marketing is crucial to success for apparels, and shopping habits alsodiffer from the West. Major shopping occasions are Labor Day, National Day, and Chinese NewYear; marketing and advertising need to be adjusted accordingly. Both Zara and H&M alsolaunched aggressive marketing campaigns when the first stores opened in China to create brandawareness

2. Regional diversity Fashion preferences differ between regions, and are influenced by level of

development, climate, customs, etc. For example, designs from Wuhan have sharp colors,Hangzhou is known for its elegant clothes, while Shenzhen and Guangzhou closely follows trendsinHong Kong.

Case Studies Return to Top

Esprit A Hong Kong company that first set up a number of direct-owned stores in Shanghai. Afterthese outlets established a brand image, franchising was used to expand in other cities. Esprit believesfranchisees can increase efficiency in local markets through local relationships and familiarity with localregulations, e.g. obtaining tax breaks for creating employment. Thus, the company places a highimportance on maintaining good relationships with franchisees. The strategy has paid off as the brand isnow one of the top foreign brands in China.

Dunhill One of very few luxury brands using the franchising model, Dunhill approached China by

starting out with regional franchises and then transitioning to directly run operations. In March 2006Dunhill established a J V company to control its most profitable / valuable outlets while regionalfranchisees remained responsible for the other stores. Since then, Dunhill has stopped openingfranchised stores because quality standards varied considerably between stores, and some stores fellsignificantly short of Dunhills luxury brand image.

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KEY INDUSTRY 3: FRANCHISING IN EDUCATION15

Note: this section will provide a brief snapshot of the education sector, with focus on a relatively moredeveloped segment, language training. More detailed information for other segments and regulationsmay be found in the Education & Training report, which is also part of the USCS-JLJ series on China.

Summary: Franchising in Chinas Education Market Return to TopThe education and training market has grown at average of about 20% annually in the last few years.Franchising is common in all of the three large segments: language training, IT training, and childrenseducation. However, foreign players are still a small part of the language training and childrenseducation segments due to restrictive regulations. Indian companies dominate the IT segment.


Education & training market. Currently, there are about 93,200 domestic and international privateeducation institutions in total. Language training (about 11% annual growth), IT training (~20% growth)and childrens education (~30% growth) are the three top segments. Demand for such services comesfrom both individual consumers and companies. Increased attention to education is also evident in therising proportion of income spent on education. The value doubled between 1999 and 2004 and

reached US$ 1,547 per capita in 2006.

Franchising. Most consumers perceive large branded chains to be more reliable. Thus, franchising ispopular as it is seen as a fast method of increasing the number of stores, and consequently increasingbrand recognition. Not all large brands franchise, however notably New Oriental and Wall StreetEnglish. In some cases, this is partly the result of restrictive regulations, especially for childrenseducation (more details can be found in the Education & Training Report) . Finally, the IT segment isdominated by global Indian companies -Aptech and NIIT which both franchise in China. This segmentis thus more competitive and offers relatively less room for new smaller entrants.

Drivers of growth. Demand for training is increasing due to shortage of qualified personnel that canmeet international standards, especially managers. Corporate training courses are also used as aretention tool by large MNCs. Demand is also driven by individuals young Chineseprofessionals arewilling to spend an average of 10% of their salaries on ongoing training. In the childrens segment,

growth is driven partly as a result of the one-child policy and fierce competition to get into the bestschools.

Competitive Landscape Language Return to Top

Tier 1 vs. Tier 2.There are more than 50,000 English language institutes throughout the country; only afew key players have national coverage, e.g. English First and New Oriental. However, the majority ofoutlets for these companies are still located in the economically developed East coast. Tier 2 cities offergood prospects as demand exceeds supply, especially since learning English has become a trendamong the younger generation and is seen as a key skill to have for significantly enhancing onescareer prospects.

Foreign vs. Domestic. Foreign companies are not preferred to domestic ones, as both can hire nativespeakers as teachers. The franchising model is used by English First and Web International (table 4)

while others engage in J Vs or partnerships with universities. 80% of domestic institutes use franchising,but many are small local companies.

15This section excludes the non-profit education sector

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Table 4 Key franchised chains in language education

BrandYear of

entry

Total

outlets

Franchised

outletsLocation Comments

International language training that do not franchise

Wall Street Englis h 2000 27 0 East China- Targets business people and mature

students.International language training franchisors

EF Foundation 1994 80 50 National

- Targets corporate, students and children.- Relatively high price.- Plans 200 franchised outlets by 2008.- Childrens education division is not

franchised

WEB InternationalEnglish

1998 60 40 East

- Targets business people and maturestudents.

- Business English and oral EnglishDomestic language training franchisors

Beijing Glo bal IELTSSchool

1997 56 40-50 National

- Caters to diverse groups.- Strong collaboration with government and

universities.

Liyang Crazy English 2003 49 39 National- For young school-age learners.- Relatively low price.

Yanghualianpian 1999 37 30 National- For all ages.- Focus on oral English.

Note: Data for Mainland China, no. of outlets approximate; National presence refers to stores in almost all provincial capitals and othercities, East China refers to cities along the East coast, spreading from Guangdong in the south to Liaoning in the north. Source: Companywebsites, phone interviews, news articles, and JLJ analysis.

Key Opportunities Language Return to Top

The maturity of the education market in the US gives US franchisors the experience and know-how tomeet new customer demands in the Chinese market, more specifically:

1. Oral English, English for young children, and professionalwriting the top three most popularsegments in Language education

2. Other languages in particular French, German, and Korean. Next to English, French has thelargest market share due to significant French investments in China and Chinese investments inAfrica. Currently, some schools focused on English offer French on the side, e.g. Beijing GlobalIELTS School.

3. Different teaching methods There is demand for greater variety of classes and teachingmethods, ranging from web-based teaching to short, intensive crash courses. For example,English First offers Internet learning through its Englishtown brand for busy adults

Key Challenges Language Return to Top

While there is a clear demand for language education in China, there are several key obstacles forforeign franchisors.

1. Returns on investment Returns are generally slow. English First had franchised all but four of its68 schools by April 2006, due to cost pressures and strict approval processes; Wall Street English,regarded as a success story among foreign institutes, took 5 years to become profitable.

2. Identifying regional needs Regional needs differ greatly. For example, Beijing is largely apostgraduate market while Qingdao is focused on high school education.

3. Regulations Due to stringent regulations, the education sectorrequires a greater commitment onthe part of the franchisor than other sectors. [More details in the Education & Training report]

Case Study Language Return to Top

English First Only uses direct-own outlets in Tier 1 but relies on franchising to expand in Tier 2. Atfirst, franchisees were actively pursued. Now, most new franchisees come via referral or expansion ofexisting franchisees. Through a dedicated franchise department, franchisees are thoroughly trainedbefore being allowed to operate under the brand. Frequent quality audits are performed to ensurecompliance.

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KEY INDUSTRY 4: FRANCHISING IN FITNESS

Summary: Franchising in the Fitness Sector Return to Top

Chinas fitness sector is still in early stages. Currently growth is limited by a general lack of awarenessof healthy lifestyle and high costs of gym memberships. Nevertheless, numerous domestic and

international clubs, e.g. Bally Total Fitness and Powerhouse, already operate mid-end and high-endclubs in Tier 1 and Tier 2 cities. The franchising model is popular and several US players alreadydominate among foreign brands.


Fitness market. The top 10 global national fitness markets account for 83% of worldwide industryrevenue, with J apan being the only Asian country in the top 10. Chinas fitness sector is in its infancyand is marked by a large number of local operators, similar to the US in the 1970s. There are severallarge brand names present, but the largest one has only about 60 stores (Weider-Tera).

Franchising. Franchising is extremely popular in the fitness sector. The majority of gyms use thefranchising model to expand as new clubs require a substantial amount of investment. Gymmembership fees are relatively high, at about $25 to $35 per month, compared to an average of $55 in

the US.

Drivers of growth. Only about 0.1% of the adult population frequents the 1,200 or so medium andlarge gyms in China, compared to 5%16 in Europe, and 20% in the US. There is thus good potential aseven an increase to 1% of gym-going population will result in a huge demand for gyms. The 2008Olympics are expected to enhance peoples passion for sports and exercise, and to convey the benefitsof a healthy lifestyle to a wider group of people. In parallel, the government launched the NationwidePhysical Fitness Program, which aims to increase health awareness and get 40% of the population toexercise regularly by 2010. Also, the growing middle and upper class population are increasinglyconcerned with well-being and image, and have enough disposable income to sign up for gymmemberships.

Key trends.The key customer group for gyms is no longer only high-income young professionals butinclude people of various ages with wider range of income17; frequency of gym visits has also increased.

Currently both men and women go to gyms, while in the past it was predominantly women. The gym isstill regarded as a place to socialize, with group classes being more popular in China than in the US.Most gyms offerawide variety of classes, ranging fromhot yoga and spinning to belly dancing.

Competitive Landscape Return to Top

Geographic distribution.The market is split between branded gym chains, small independent outlets,and hotel gyms. Current demand in Tier 1 cities is met by middle to high-end chains, some of whichhave already expanded into Tier 2 cities. However chains have a highly regional focus, and there arestill no gyms with national coverage. For example, while Bally Total Fitness is concentrated in the North,Total Fitness is mainly in the South.

Tier 2 markets. The fitness market in Tier 2 cities is only just starting to develop. Outside of the keyTier 1 markets, the number of gyms for any brand in a Tier 2 city is usually only 1 or 2. For example,

Bally Total Fitness, has 8 locations in Beijing and only 1 to 2 locations in other cities where it is present such as Dalian and Changsha. The table below shows the key fitness clubs in China and theirpresence.

16The average percentage for 16 European countries. In decreasing order these are: UK (10.13%), Sweden, Switzerland, Spain, Greece, Austria,Germany, Netherlands, Italy, France, Belgium, Denmark, Portugal, Slovenia, Croatia, and Poland (1.13%).17 Note that with annual fees ranging into the thousands of RMB ( ~US$ 300 onwards ), memberships are still a big-ticket item for many people.

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1. Qualified personnel Since the fitness industry is still in its infancy, there is a lack of people whoconsider it a place for a long-term career. Up until 2002, there were very few or no certified personaltrainers. Currently some 80% of certified fitness trainers received their credentials from the AsianAcademy for Sports and Fitness Professionals, a Hong Kong institution that operates according tointernational standards.

2. High investment requirements Significant start-up capital is required for gyms due to high costsof renting / buying a location as well as equipment. It may be difficult for franchisors to find well-qualified franchisees that have the financial resources to invest. Many franchisors thus look topartner with real estate companies to offer gyms in condominium / residential complex.

3. Demand still yet to take off The pool of potential members is growing, but still limited as gymmemberships are still an expensive item. Nevertheless, all major international gyms are already inChina, and competition to sign up members is intense, especially in Tier 1 cities.

Case Study Return to Top

Weider-Tera Tested the franchising model but has reclaimed many franchised gyms and has noplans to open franchised stores in the coming years. Franchisees lack of management, poor knowledge

of fitness, and inferior equipment purchases led to the change in strategy. Now Weider-Tera expandsvia J Vs, where they provide part of the start-up capital and assistance in other areas e.g. locationsearch, equipment import, and setting up daily operations. To maintain service quality, managementcontrol is within Weider-Tera.

CSIBally Total Fitness In 2002, BTF formed a J V with the China Sports Industry Group (CSI).Combining CSIs market knowledge with BTFs experience in fitness and management, the companyentered Beijing. It opened two direct-run outlets in Beijing and had opened its 10

thChina franchise by

August 2004. It is now the second-largest foreign gym chain in China after Weider-Tera.

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SNAPSHOT OF SELECTED TIER 2 CITIES

Overview Return to Top

The following section provides a snapshot of franchising in 10 cities 6 cities presented in greaterdetails, and another 4 in brief. The 6 key cities for franchising are Tianjin, Qingdao, Nanjing, Shenzhen,

Xian, and Chongqing, as shown in the map below.

Source: JLJ analysis

The following table shows the key indicators for the ten cities, with Tier 1 cities provided for comparison.The numbers of outlets for two key foreign F&B chains are included as they are a good indicator ofoverall purchasing power in the city - KFC representing fast food segment, and Pizza Hut representingthe casual dining segment.

Table 7 Key indicators by city

RegionPopulation

[M]

Per capita

urban

disposable

income

[2005, $]

Per capitadining out

spending

[2006, $]

Per capitaeducation

spending

[2006, $]

No. of fitness

club

ranking20

Investment

Climate

ranking21

No. of

KFC

No. of

Pizza

Hut

Beijing 15.8 2,323 174 n/a 1 23 135 40

Shanghai 13.7 2,390 190 157 2 17 166 52

Shenzhen 8.4 2,755 165 152 3 2 95 18

Tianjin 10.6 1,620 126 92 10 19 52 6

Nanjing 7.0 1,923 86 120 Not in top 10 21 44 9

Qingdao 7.5 1,656 109 98 9 7 28 3

Chongqing 28.0 1,313 112 9922 8 98 17 4

Xian 8.1 1,234 11422 12122 Not in top 10 70 7 4

Dalian 6.0 1,538

N/A

9 11 26 6

Shenyang 7.0 1,295 Not in top 10 43 37 4

Hangzhou 6.6 2,128 7 13 53 12

Suzhou 7.8 2,087 Not in top 10 3 28 4Source: National and Provincial Bureaus of Statistics, Ministry of Commerce, WTO, Fitness China, company websites, and J LJ analysis.Note:Pizza Hut in China is positioned as a casual dining restaurant.

20According to Fitness China 2007, which presents a list of the top 10 fitness cities in China, according to number of gyms. Note: Qingdao shared9thplace with Dalian and Harbin, Chongqing shared 8th place with Changsha.21According to the 2006 WTO report China: Governance, Investment Climate, and Harmonious Society: Competitiveness Enhancements for 120Cities in China.22 2005 figures

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Shenzhen Return to TopMacro-economic overview. Shenzhen, the first city in China to be designated as a Special EconomicZone, is located in the Pearl River Delta in Guangdong province. The citys superior geographicallocation is one of the reasons for its rapid economic development in the last decade. Besides beingnear the Pearl River which facilitates domestic connectivity, Shenzhen is also only a short distance

away fromHong Kong

. With a GDP per capita of about $8,904,Shenzhen

is one of the wealthiest citiesin China. The city is also a popular location for foreign investors, attracting $3.2 billion worth of FDI in2006 (about 4.6% of China total).

Franchising. Foreign brand acceptance is high due to its proximity to Hong Kong, which has fosteredShenzhens rapid economic rise through foreign capital and the introduction of foreign brands. Themacro-economic indicators in table 7 indicate that Shenzhens population is willing and able to spendmoney on food and education at levels close to those ofShanghai. Its fitness market is the third largestin China.Per-capita expenditure spent on fitness increased 20% in 200623. Major franchise brands havea presence in Shenzhen, includingAdidas, BlenzCoffee, Subway, and Taipei Ice House.

Potential partners. Due to Shenzhens open climate and proximity to Hong Kong, most reputablepartners are either international or from Hong Kong, with Jinjiang representing the only domesticcompany. Real estate companies are included as potential partners, especially for fitness franchises.

Cheung Kong Ltd Leading Hong Kong based group active in 55 countries. Its portfolio includescommercial and residential property development in 15 Mainland Tier 1 and Tier 2 cities.

China Everbright International Ltd Property & infrastructure developer fromHong Kong with itsmajor Mainland properties situated in Shanghai and Shenzhen.

Fu Wah International Group A Hong Kong based multinational with a diverse portfolio thatincludes real estate, hotels, clubs and tourism. Active primarily in Beijing.

Jinjiang International One of Chinas leading hospitality groups with business including hotels,food, travel, and real estate. Present in ~22 Tier 1 and Tier 2 cities.

New World Development Company Hong Kong group that manages hotels (Beijing, Shanghaiand ~4 Tier 2 cities), property and department stores (both in ~16 Tier 1 and 2 cities).

Tianjin Return to Top

Macro-economic overview. One of the three Autonomous Municipalities in China, situated in theBohai Economic Zone one of the three largest nationwide. This regional financial hub has beentargeted by Beijing to become the center of the region through preferential policies and a free tradezone. It is already one of Chinas wealthiest Tier 2 cities, Northern Chinas largest commercial port, andis well connected to other cities.

Franchising. Current disposable income and dining out levels indicate that there is a market for food(especially casual diners) and fashion franchises. There may be a smaller demand for education,considering the relative lower amount spent on education compared to other cities. Tianjin has about 43gyms, 26 of which are franchised stores. Existing franchises include Macros, Mizuno, and Subway.

Potential partners. Tianjin is also dominated by Hong Kong and foreign groups. Haohua is a domesticcompany with a diverse business portfolio and active only in Tianjin.

Tianjin Haohua Group 24 Local group with a portfolio including business hotels andentertainment. Its hospitality business is located solely in Tianjin.


New World Development Company Hong Kong group that manages hotels (Beijing, Shanghaiand ~4 Tier 2 cities), property and department stores (both in ~16 Tier 1 and 2 cities).

23Per-capita expenditure on fitness is currently not separately recorded in RMB but as a part of the larger per-capita expenditure on entertainment

and fitness indicator.24 The Chinese name is, as the company can be difficult to find without knowing the Chinese written name.

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Nanjing Return to TopMacro-economic overview. Nanjing, the capital of Jiangsu province, ranks among Chinas mostrapidly growing cities. The GDP ofJiangsu province, at $276 billion, is ranked third in China overall afterGuangdong and Shandong. Nanjing has a GDP of $35.6 billion is also an attractive destination forforeign investment. Over 1000 American companies are doing business in Nanjing and the US rankedNanjing as its second largest trading partner after South Korea.

Franchising. Dining out levels in Nanjing are comparatively low while expenditures on education arequite high. The fitness market is still relatively undeveloped as Nanjing did not figure in the top ten.Present franchises include Burger King, Little Caesars, SDEER, and Subway.

Potential partners. There are several reputable domestic groups based in Nanjing while there isrelatively less presence of Hong Kong and foreign groups.

Jiangsu Yueda25, Based in Jiangsu province, Yueda has a diverse portfolio of products. Most ofthis does not center of F&B, but Yueda is J V partners with Carrefourand recently with UK chainCosta Coffee inShanghai. It is present in a number of Tier 1 and Tier 2 cities.

Jinling Hotels & Resorts Focused on hotels and resorts with some 18 locations, most of whichare in Tier 1 to Tier 3 cities in Jiangsu province.

Suning Group Chinese group famous for its electronics and appliances. Its portfolio in Nanjingalso includes hotels and real estate.

Qingdao Return to TopMacro-economic overview.Qingdao occupies a prime geographical position in the East Asian market,close to both Korea and J apan. It is also one of the largest ports in China, the major commercial centerofShandong province, a popular tourist destination, and a favorite spot for FDI. During the past years,FDI in Qingdao has risen to among the highest in China to reach $3.7 billion in 2007.

Franchising. Resulting from its colonial history, people are familiar with foreign influences and brands,Income and expenditures on dining out and education are at reasonably high levels. Qingdaos took 7

th

place in the fitness top ten, and interest in fitness can be expected to grow as Qingdao is the venue forthe 2008 Olympic water sports events. In 2006, 44 gyms existed in the city, 12 of which were franchised

Franchised brands already located there include Jack & Jones, Lejazz and Little Caesars.

Potential partners. Qingdao presents an even mix of potential domestic, Hong Kong, and foreignpartners.

Gloria Hotels & Resorts Chinese hospitality group present in some 13 Tier 1 and Tier 2 cities.


Shunfeng Food & Recreation Domestic restaurant and recreation group present in all Tier 1 andfour Tier 2 cities: Qingdao, Xian, Shenyang and Jinan.

Qingdao Construction Group Construction group that also deals in real estate in Qingdao.

Chongqing Return to TopMacro-economic overview.Chongqing is the youngest but largest autonomous municipality in China.Previously part of Sichuan province, Chongqings reclassification as an autonomous municipality in1997 was a significant step in government efforts to develop central and Western China. Chongqing isan important economic and industrial center for the Southwest region. Upon completion of the ThreeGorges Dam project, ocean-going ships will be able to reach Chongqing.

Franchising. The presence of foreign brands is still relatively limited compared to other Tier 2 cities, asits purchasing power is still low. Regardless, franchised brands such as Adidas, Lejazz, and Little

25Although most ofYuedas portfolio does not center on F&B, it partners with Carrefourand recently with Costa Coffee inShanghai.

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Other Tier 2 markets Return to TopDalian. With a population of 6 million, it is the second biggest city in Liaoning province, whose port andstrategic location has been the key to its rapid growth and development. Dalian has the largest deep-water port in Northeast China, and strong international trade links. The city is also equipped withadvanced infrastructure capable of supporting sophisticated logistics needs. In 2006, its GDP reached

$33 billion. Dalian is also a major industrial base and one of the largest oil refinery bases inChina.Currently established franchised brands include Little Caesars and Subway.

Shenyang. Capital city of northeastern Liaoning province, the city is an important industrial center inChina and the regions top commercial and logistics hub. In recent years it has made opening up to theoutside a top priority. Traditionally focused on heavy industry, it has recently begun developing thesoftware, automotive and electronic sectors. Franchised brands such as Blenz Coffee and Subway arepresent.

Hangzhou.Hangzhou is the provincial capital ofZhejiang, the fourth largest production base in China,which also ranks fourth in GDP among all provinces. Hangzhou is an economically dynamic cityattractive to foreign investment. The GDP ofHangzhou grew 17% to reach $44.1 billion in 2006. Thecitys disposable income also ranks among the top few cities in China. Hangzhou is also equipped withmodern transportation facilities and is linked to Shanghai and surrounding cities by a number of

expressways. Banana Leafand Macros are some of the locally present franchised brands.

Suzhou. Suzhou, located in Jiangsu province, ranks among Chinas most rapidly growing cities.Famous throughout history for its silk production, Suzhou is now a major international hi-tech productionhub as well as a manufacturing base for other products including steel, chemicals, paper, machine toolsand motor vehicles. In 2006, the city achieved a GDP of US $61.8 billion. Suzhou has experienced animpressive average annual growth rate of about 17 percent in recent years, and has become a majortarget of foreign direct investment - over US $6 billion in 2006. Brands that are franchised include BlenzCoffee and Little Caesar.

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CONSIDERATIONS FOR US COMPANIES AND CONCLUSIONS

Key Considerations Return to Top

Key opportunities. The previous sections highlighted the key opportunities for US companies in thefour sectors. In general, middle to high-end positioning and high quality products are increasingly in

demand. This is driven by the growth of the middle class27.The middle class currently constitute 5% ofhouseholds, but are expected to increase to 45% of all households by 2020. This presents significantlong term potential, and is part of the reason why some foreign companies that use the franchisingmodel overseas choose to invest in direct-owned outlets in China, as the potential revenue generatedby direct-ownership of stores is higher.

Chinese companies may lack management skills and suffer from a lack of consistency across stores. Inaddition, investment in R&D and product development is generally low. US companies possess theexperience, skill, and know-how for establishing smooth-running outlets, and such consistent brandingis key to success.

Key challenges. Although there is a market for the products/services of foreign franchisors, there arestill significant challenges in adopting the franchising model, as highlighted below:

1. Finding good partners - In many Tier 2 cities, there are generally only a small handful of potentialpartners that fit the profile for what many foreign companies are looking for in J V partners. Potentialpartners usually have capital, but they need to be convinced of the potential of the foreign brand,and its track record in other countries and in China. Generally, potential partners prefer brands witha good international track record (especially in Asia).

2. Managing franchisees It is generally difficult to find and manage franchisees, especially in Tier 2cities. Although franchising fees are generally not the issue, start-up costs can be prohibitive due tohigh rents. Many local franchisees do not follow franchise standards, and sacrifice brand image forshort-term profits. Thus comprehensive contractual arrangements are necessary, including thosethat look out for the franchisees interests (satisfied franchisees are more likely to abide by therules). More time and effort needs to be put into providing training support.

3. Staffing At store level, the talent market for store managers is very competitive, and it is even

more pronounced in Tier 2 cities. Direct-owned chains, like Starbucks or Haagen-Dazs, have directcontrol over recruitment and retention, generally offer higher salaries for store managers, and areable to devote more resources into training. Most local staff in Tier 2 or 3 cities also need rigoroustraining, as they have relatively limited exposure to Western chains and service concepts. Direct-owned chains regularly transfer store managers from Tier 1 cities to manage new store openings inTier 2 or 3 cities and to train local staff, whereas this may not be feasible for franchised chains.

4. Localization Differences between US and other countries always mandates a certain amount oflocalization in international expansion. In addition to major differences between the US and China,there are also regional differences within China. It is therefore important to thoroughly analyzepotential markets and to never assume success in one region will guarantee success in another.

5. IPR issues While Chinas IP laws are on par with international standards, they suffer from a lackof enforcement. The responsibility to track down businesses that infringe on IP rights often falls on

the IP owner.Companies should register all trademarks, brand names (both English and Chinese),URLs, and patents before entering the market.

Market Access Return to Top

Market entry options.There are two main options available for foreign franchisors looking to enter theChinese market: 1. Engage in cross-border franchising. 2. Establishing a Foreign-Invested Enterprise(FIE) such as a J V or WOFE, as shown in the following chart.

27 Defined by the National Bureau of Statistics as households with annual income of $7,230 to $60,240

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1. Cross-border franchising The May 2007 regulations have made it fully legal to use cross-borderfranchising, where the US franchisor (with at least two successful stores overseas) sign a franchisecontract with the master franchisee in China, without have a local presence in China (Example A inchart below). However, this method results in a great loss of control and supervision over thefranchise as the franchisor has no legal entity in China.

2. Foreign direct investmentThis involves establishing either a J V or WOFE. The overseascompany can set up a WOFE/J V, and at the same time do cross-border franchising, where the

overseas company is the franchisor (Example B in chart below). However, if the WOFE or JV is tobe a franchisor, then it is required to have owned and operated at least two successful stores for atleast one year, before it can use franchising (Example C in chart below). While this information isbased on interviews with the Ministry of Commerce (MOFCOM), it must be noted that this law is stillrelatively new, and how it is implemented in practice is still unclear; implementation may also varyby region. More time is needed to observe which structures are approved (or rejected) in practice.

Source: Interviews with Ministry of Commerce, China Chain Store & Franchise Association, and J LJ analysis. Note: the abovecharts are simplifications, and more complex models are possible, for example if the franchisee can engage in sub-franchising.

Tier 1 vs. Tier 2 entry strategies. Entry via Tier 1 cities has been the dominant strategy for themajority of foreign companies since these cities have the largest and most open markets. It is mostcommon for franchisors to establish a J V or a WOFE in Tier 1 cities to set up supply chain networks,and establish brand image through a few direct-owned stores. Further store expansion are done either

through direct-owned stores, partnerships, or franchising. With Tier 1 cities becoming increasinglyexpensive and competitive (e.g. many foreign brands present, difficult to find good locations, etc), manycompanies are considering entering via Tier 2 cities.

Entry via Tier 2 cities has not yet been done by many companies, but Dunhill, for example, entered viaTier 2 markets and later expanded into Tier 1 cities. There are several barriers for entry via Tier 2 cities.Purchasing power is rapidly growing, but still limited; Tier 2 markets are also fragmented, characterizedby a large number of potential cities, that can each accommodate only a few number of stores. Forexample, KFC, a relatively mature brand in China, has less than 20 outlets in Chongqing compared tomore than 150 in Shanghai. The implications include release of products in smaller volumes and atreduced prices.

Conclusions Return to Top

China is becoming increasingly attractive to foreign franchisors. However, there are several barriers tousing the franchising model including difficulty in finding franchisees and in maintaining standards. As aresult, many foreign franchisors have chosen not to use franchising in China, instead opting for direct-run stores and partnerships. In all cases, a significant amount of time, effort, and resources are stillnecessary to maintain the quality of store operations. Companies should also seek professional advicewhen planning their China strategy.

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TRADE EVENTS Return to Top

Franchising China 2007 exhibitionLocation: Shanghai, Guangzhou, BeijingDate: 8-9, 12-13, 15-16 November 2007Website:http://www.franchise.ceconline.com:80/HOME_EN.HTMChina Franchise Expo 2008Location: BeijingDate: 19-21, April 2008Website:http://www.chinafranchiseexpo.com/asic/e.htmShanghai International Franchise Exhibit ionLocation: ShanghaiDate: August 2008Website:http://www.ccfa.org.cn/sh/e_Why%20to%20Exhibit.htm.htmChina International Hospitality Industry ExpoLocation: to be confirmed, likely BeijingDate: to be confirmed

Website:http://www.hosexpo.com.cn/en/info.asp

RESOURCES & KEY CONTACTS Return to Top

China Chain Store & Franchise AssociationTel: +86-10-51916555 ext.8043Website:http://www.ccfa.org.cn/english/

Ministry of Commerce of the PRCTel: +86-10-65284671Website:http://english.mofcom.gov.cn/Ministry of Education of the PRC

Tel: +86-10-66096114Website:http://www.moe.edu.cn/englishAsian Academy for Sports & Fitness ProfessionalsTel: +852-2578-9877Website:http://www.aasfp.com/main.htm

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Methodology

This research is based on a combination of secondary and primary resources as well as a continuousanalysis and elaboration of all key facts and data throughout the research. Secondary resources includedThe J LJ Group, US Commercial Office, World Trade Atlas, China Customs, China Statistics Bureau, andother sources. Primary resources include interviews and interactions with key industry players.

About the authors

The U.S. Commercial Service Your Global Business Partner

With its network of offices across the United States and in more than 80 countries, the U.S. CommercialService of the U.S. Department of Commerce utilizes its global presence and international marketingexpertise to help U.S. companies sell their products and services worldwide. Locate the U.S. CommercialService trade specialist in the U.S. nearest you by visiting http://www.export.gov/.

The U.S. Commercial Service in Beijing, China, can be contacted via e-mail at: Frank.J [email protected]: +86-10-8529-6655. Fax: +86-10-8529-6558 or visit our website: www.buyusa.gov/your_office.

The JLJ Group Solutions for China Entry & Growth

The J LJ Group is a one-stop service provider assisting international companies entering or growing in theChina market. J LJ has already served more than 400 clients including Fortune 500, SMEs andgovernment organizations - in more than 10 years of activity in China. J LJ provides services in five areas Market Research & Consulting, Corporate Formation, Human Resources, Tax & Accounting and BusinessProcess Outsourcing to support the business needs of foreign companies at different stages of their Chinaprojects.

The J LJ Group in Shanghai, China, can be contacted via e-mail at [email protected] or phone: +86-21-5211-0068. For more information visit www.jljgroup.com

Disclaimer: The information provided in this report is intended to be of assistance to U.S. exporters. While we makeevery effort to ensure its accuracy, neither the United States government nor any of its employees make anyrepresentation as to the accuracy or completeness of information in this or any other United States governmentdocument. Readers are advised to independently verify any information prior to reliance thereon. The informationprovided in this report does not constitute legal advice.

International copyright, U.S. Department of Commerce, 2007. All rights reserved outside of the United States.

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